Columbus Partnership Feb. 17, 2006

1. Our Fiscal Futureand Economic ProspectsJeffrey FrankelHarpel Professor of Capital Formation and GrowthHarvard University Columbus Partnership Feb. 17, 2006

2. Short-term economic outlook • The White House has just released its budget and the Economic Report of the President • The Council of Economic Advisers is forecasting good output growth of 3.4% this year. • 3.4% is readily attainable. But • Jobs have lagged far behind growth • This ERP gives up on goal of raising employment/population back up in the direction of January 2001 level. • Real wages have stagnated too. • => Growth is all going to profits. • There are also substantial risks to the global outlook

3. Medium-term global risks • Hard landing of the $: foreigners pull out => $ ↓ & i ↑ => possible return of stagflation . • Bursting bubbles • Bond market • Housing market • New oil shocks, • e.g., from Russia, Venezuela, Iran, S.Arabia… • New security setbacks • Big new terrorist attack, perhaps with WMD • Korea or Iran go nuclear/and or to war • Islamic radicals take over Pakistan, S.A. or Egypt

4. Trade balance is deteriorating

5. Trade deficit • Goods & services deficit for 2005released by BEA Feb.2 : • $725.8 b > 6% GDP, arecord. • Would set off alarm bells in Argentina or Brazil • Short-term danger: Protectionist legislation, such as Sen. Schumer’s bill scapegoating China • Medium-term danger: • CA Deficit => We are borrowing from the rest of the world. • Dependence on foreign investors may => hard landing • Long-term danger: • US net debt to RoW now ≈ $3 trillion. • Some day our children will have to pay it back => lower living standards. • Dependence on foreign central banks may => loss of US global hegemony

6. Origins of Current Account deficits • Trade deficits are not primarily determined by trade policy (e.g., tariffs, NAFTA, WTO, etc.) • Rather, by macroeconomics • Deficits are affected by exchange rates and growth rates. • But these are just the “intermediating variables” • More fundamentally, the US trade deficit reflects a shortfall in National Saving

7. The decline in US National Saving • National Saving ≡ how much private saving is left over after financing the budget deficit. • US CA deficit widened rapidly in early 1980s, & more so 2001-05, because of sharp falls in National Saving

8. National Savings, Investment & Current Account, as shares of GDP

9. Why did National Saving fall in early 1980s, and 2001-05? • The federal budget balance fell abruptly both times • From deficit = 2% of GDP in1970s, to 5% in 1983. • From surplus = 2% GDP in 2000, to deficits >3% now. • According to some theories, the pro-capitalist tax cuts were supposed to result in higher household saving. • Both times, however, saving actually fell after the tax cuts. • U.S. household saving is now < 0 ! • So both components of US National Saving fell.

10. What gave rise to the record federal budget deficits? • Bush Administration: Large tax cuts, together with rapid increases in government spending • Parallels with Reagan & Johnson Administrations: • Big rise in defense spending • Rise in non-defense spending as well • Unwillingness of president to raise taxes to pay for it. • Leads to declining trade balance • Eventual decline in global role of the $. • They had ignored the advice of their CEA Chairmen.

12. What about the “Starve the Beast” hypothesis? • History shows that the Starve the Beast claim (“tax revenue↓ => spending↓”) does not describe actual spending behavior. • Spending is only cut under a regime of “shared sacrifice” that simultaneously raises tax revenue (the regime of caps & PAYGO in effect throughout the 1990s) • Spending is not cut under a tax-cutting regime (1980s & current decade). • See Figure 2.

13. Fig. 2: US Federal Budget Deficit and Spending as % of GDP.

14. Further, even if the Starve the Beast hypothesis did describe actual behavior… • It would contradict the original rationale for the tax cuts: the Lafferite hypothesis that “tax rate cuts produce more tax revenue.” • “Starve the Beast” would then predict more government spending not less. • Is Laffer a straw man? • President George W. Bush, July 24, 2003 • OMB Director Joshua Bolten, press conference July 2003; & WSJ, Dec. 10, 2003 • Treasury Secy.John Snow, Congr. testimony, Feb. 7, 2006: “Lower tax rates are good for the economy and a growing economy is good for Treasury receipts.”

15. White House forecast of cutting budget deficit in ½ by 2009 will not be met • WH projections just released still do not allow for • the ongoing cost of Iraq • Fixing the Alternative Minimum Tax • Making permanent the tax cuts as it has asked for • More realistic forecasts of spending growth, e.g., in line with population. (Actually spending growth since 2001 has far exceeded that.) • More likely, deficits will not fall at all. • Just as the budget forecasts were predictably overoptimistic throughout the first Bush term. • The surplus of $5 trillion+ forecasted in Jan. 2001 over 10 years has become a 10-year deficit of $5 trillion+ .

16. White House Budget Balance forecasts have to be revised down every year Source: Office of Management and Budget

18. Further, the much more serious deterioration will start after 2009. • The 10-year window is no longer reported in White House projections • Cost of tax cuts truly explode in 2010 (if made permanent), as does the cost of fixing the AMT • Baby boom generation starts to retire 2008 • => soaring costs of social security and, • Especially, Medicare

19. Appendix 1: Many economists have come up with ingenious counter-arguments to these deficit concerns. • But I don’t buy them. • I.e., the twin deficits that face us now and in the future should indeed be a source of concern • Low US national saving is roughly a “sufficient statistic” for the problem.

20. 7 alternate views that purport to challenge the “twin deficits” worry • The siblings are not twins • Alleged Investment boom • Low US private savings • Global savings glut • It’s a big world • Valuation effects will pay for it • China’s development strategy entails accumulating unlimited $

21. Appendix 2: Possible loss of US economic hegemony. • US can no longer necessarily rely on the support of foreign central banks, such as China. • China may allow appreciation of RMB. • Even if China keeps RMB undervalued, it can diversify its currency basket out of $ • There now exists a credible rival for international reserve currency, the € . • Chinn & Frankel (2005): under certain scenarios, the € could pass the $ as leading international currency. • US would lose, not just seignorage, but the exorbitant privilege of playing “banker to the world “

22. Possible loss of US political hegemony. • In the 1960s, foreign authorities supported $ in part on geopolitical grounds. • Germany & Japan offset the expenses of stationing U.S. troops on bases there, so as to save the US from balance of payments deficit. • In 1991, Saudi Arabia, Kuwait, and others paid for the financial cost of the war against Iraq. • Repeatedly the Bank of Japan bought $ to prevent it from depreciating (e.g., late 80s) • Next time will foreign governments be as willing to bail out the U.S.?

23. Historical precedent: £ (1914-1956) • With a lag after US-UK reversal of ec. size & net debt, $ passed £ as #1 international currency. • “Imperial over-reach:” the British Empire’s widening budget deficits and overly ambitious military adventures in the Muslim world. • Suez crisis of 1956 is often recalled as occasion when US forced UK to abandon its remaining pretensions to an independent foreign policy; • Important role played by simultaneous run on £.